Who said tax is boring?

Archive for the month “October, 2012”

When former US President Herbert Hoover flew down to Argentina in 1946 it was to request that the newly elected President Juan Peron order a massive grain shipment to Europe aimed at staving off a post-war famine. Following his successful mission, he commented that Peron’s young wife, Eva, had the brains of Eleanor Roosevelt and the looks of Hedy Lamarr. Fortunately for Europe, Hoover was more astute at organizing famine relief than identifying imminent Great Depressions or dumb blondes. Hedy Lamarr, although unquestionably a Hollywood bombshell, had a few years earlier patented a wireless concept that is today used in cellular technology. Her hair, incidentally, was brown.

After World War II, the problem was not that there was not enough food to go round but rather that it was in all the wrong places. In fact, apocalyptic predictions by the Reverend Thomas Malthus during the 18th century that population growth would outstrip increased food production had long ago been proven wrong by the Industrial Revolution that Malthus had failed to take into account (which was probably because it hadn’t happened yet). So once the 20th century had managed to put two world wars behind it, it was ready for the patter of lots of baby booming feet.

Well babes, it looks like things got a bit out of hand and, now, with a world population of 7 billion, predicted by the UN to hit at least 9 billion before (possibly) tapering off somewhere between 2040 and 2075, the late Malthus is firing on all cylinders. Somebody has decided that current food technology can support up to 10 billion on the planet which, depending on the accuracy of UN statistics, could mean that world citizen number 10,000,000,001 might be very hungry.

GDP Growth In 7 Easy Lessons

Meanwhile, economists and politicians look aghast at China’s one child policy and bemoan their own falling populations resulting from average family birthrates of one child and a bit. Although all the bits add up to whole people (vicious and entirely unfounded rumour has it, those with earrings in their mouths and spikes in their hair), this is not enough to ensure that countries’ gross domestic product can be kept at sufficient levels to support increasingly aging populations and payment of debt resulting, in part at least, from the excesses of their ancestors.

The orthodox approach to the world economy appears to be to encourage an increase in the birthrate in developed economies (Nobel laureate Paul Samuelson advocated tax breaks for having children and sired six of them himself), and encourage increased consumer demand around the globe (Nobel Prize Laureate Paul Krugman and just about everyone else) within the constraints of sound fiscal policy. Whenever I think of this set up, apart from the moral ambiguities involved, I get nervous. My thoughts invariably drift to an Aston Martin DB5 (what the only REAL 007 drove 50 years ago), its brake cable cut, hurtling down a zigzagging mountain road. It might make it and it might not. There is just too much risk in the model. Will population growth taper off in time in the developing world as those countries develop a large middle class? Will developed countries manage to clear enough debt for taxation and other components to cover spiralling pension costs? Will unchecked, ever-increasing consumer demand blow the whole system apart? And we have not even touched on the whole Sustainability thing.

“If you mention Ricardian Equivalence once more, we will invade you”

Of course, not all is black. For example, Okun’s Law (otherwise know as Okun’s Rule of Thumb because, like so much in economics, it is just an observation of what happened) says that as GDP increases unemployment does not decrease proportionately. Why not? Because there is increased productivity in the workforce. Now, while this might not be good news for a President seeking re-election it is good news for a country with a declining birthrate and lots of golden-agers. On the other hand there are economic concepts floating around like Ricardian Equivalence that suggests that there is no difference between financing government expenditure through debt or taxation. Fortunately for the sane at heart, the first person to express doubt about the validity of this theory was none other than David Ricardo after whom it is named. It was left to a bunch of junkies in the ’70s and ’80s who believed that mankind operates with rational expectations to hallucinate that it might actually be true.

The time has come to be reminded that economics is about maximising welfare, not GDP. As developed economies successfully put the current world financial crisis and their pockets of poverty behind them, they need to move away from the Holy Grail of per capita GDP growth uber alles and look to what America’s Founding Fathers cutely called “the pursuit of happiness”.

It is widely considered that the engine for increased consumer demand in the coming years has to be China and India. Both have disappointed until now. If, following the changing of the guard in Beijing in November and the recent cautiously optimistic statements of the new/old Indian Finance Minister, their consumer and capital markets open up, there will be the opportunity for demand to be slaked in the developed world by purchases from the developing world while developed world countries could invest more massively in the developing world. If this was not achieved by the market it could be achieved by governments encouraging or forcing residents to save and then investing the proceeds in, effectively, sovereign wealth funds the profits and proceeds of which could be used to cover pension and social welfare costs. In other words, rather than relying on increased population at home either due to increased fertility or politically unpopular immigration, developed countries would effectively benefit from a bigger part of the growth of the developing world than the current demand-crazed system allows for. In the meantime, as the developing world gradually settles down into bourgeois living, there will have been time for the developed world to substantially increase the retirement age and repay its sovereign debt.

At that point (in my dreams) the world could embark on an era of prosperity with calmer consumer demand which would discourage, as we saw a few days ago, the launching of a new iPad every seven months.

When my beloved Volvo (see last post) came back from the puncture place – I don’t know what they are officially called – it did not, of course, have one new tire but three. This initially gave me some comfort in that, perhaps the workers at the tire factory would also give me a thumbs-up for admittance through Heaven’s door when the time eventually came. Then I noticed that they were Michelin. French. Fat chance.

One of my first memories as a child is of the working forge across the road from our home where rag-and-bone men and other deniers of the 20th century could take their carthorses to be shod. A couple of days ago I was driving with my son through an ultra-orthodox enclave, where the regular upkeep of roads is evidently far too temporal an issue for the local council to be bothered with, when I realized that I had a puncture. I have been changing wheels for over 35 years on an array of semi-roadworthy vehicles that generally departed my ownership straight for the great carpark in the sky. But this was the first time I was shodding my precious Volvo, purchased 3 years ago after I was finally persuaded that as, of the 150 cars in the firm’s fleet, my faithful Mazda (of blessed memory) was the only one built in the second millennium, it just had to go.

Beats white gloves

Opening up the boot (trunk in foreign English), and raising the floor, we found suitable cavemen drawings explaining without resort to Swedish idiom, what we had to do. But there was one thing that captured my interest. My son who – being of the new generation that knows how to work things out from cavemen drawings – had a much better handle on the situation, produced a pouch containing a pair of white cloth gloves and a large plastic bag. The pictures on the plastic bag led us to understand that the gloves were to protect my lily- white hands as I wrestled with the jack and crippled wheel while the bag was for the offending wheel. This was presumably to protect the seldom spied underfloor of my boot (trunk) from annoying dirt. My first thought was “How bloody ridiculous”. My second thought was “I wonder what they put in the back of a Bentley – a cocktail cabinet to take your mind off things while they airlift a new tire in by helicopter?”. It was only on the way home, wearing the daft gloves to prevent my grease-ridden hands ruining the steering wheel, that I got to thinking about the utter absurdity of it all. Modern life, that is.

Regular readers of this blog will know that I am fond of Charles Dickens. Probably because of the socially reduced circumstances of much of his youth, Dickens loved to send his characters out on the open road. From the moment of his debut novel, the wealthy Samuel Pickwick and his friends would bundle up and climb atop a horse-drawn coach to be bounced around and exposed to the elements through a long winter’s night of travel. Less than 200 years later, in western countries at least, a run-of-the-mill factory worker can climb inside his motor car in the middle of winter, turn on the heater to shut out the cold and arrive at his destination in a fraction of the time, protected from shock by a suspension system and, if not choosing the same enclaves as me, suitably inflated pneumatic tires. It is fair to say that any person in modest employment today lives in greater bodily comfort than a King 200 years ago.

That in itself is wonderful and may the rest of the world catch up soon – but there is a dark side and my white gloves are a small pointer.

Most of my generation were raised to consider frugality a virtue. Just as it took me until past my 50th birthday to be persuaded to succumb to an elevated motor experience (I justified it on long-term financial grounds that my wife refuses to believe), I have – to this day- never owned any product of a certain fruit company, be it pod, pad or phone. The reason is simple – I have never felt I needed any one of them, and that is my litmus test. Apart from that I buy most of my clothes in the above-mentioned enclave where you can get any colour you like as long as it is black, grey or blue – which is good enough for me (I have a Christian Dior tie, still in its box, lying in my wardrobe, that was a gift several years ago).

Charlton Heston playing Ralph Nader

If modern economics is to be believed, when I finally get to the Pearly Gates, the only slim chance I have of being admitted to Heaven will be thanks to the pleas of those poor Chinese and comfortable Belgians who make all the bits for my no-longer-Swedish Volvo. It appears that my frugality has been depriving the world. And when you have a population that has grown in the space of 85 years from 2 billion to 7 billion and shows no signs of slowing down in the immediate future – that is a lot of world to deprive. Evidently, while I was sleeping, somebody tampered with the Ten Commandments. We are now told: Forget the Sabbath day to keep it commercial; Covet thy neighbour’s SUV; Honour thy children’s credit card bills.

When they are not talking about destroying Europe with austerity, politicians and economists are talking about expanding demand. Germany has to inflate to save the Euro, China has to open its economy to more foreign investment and concentrate on consumer demand, India has to grow, not just for itself, but to import from the west and taxes or debt have got to finance the growing social security costs of stubbornly aging populations. So our Fridges die after 5 years, our cars are replaced every 3 years (over my dead body), our mobile phones are outdated by the time they leave the factory and manufacturers come up with things you didn’t know you didn’t need like white gloves (why white for heaven’s sake?) and body bags for dead tires buried in the bottom of your car…

M.A.D. has to be the best acronym ever. “Mutual Assured Destruction” is what the world looked like it was heading for 50 years ago this week when the young John F Kennedy faced down Nikita Khrushchev in the Cuban Missile Crisis. October 16, 1962 has gone down in history as the morning National Security Adviser McGeorge Bundy walked into the Oval Office to show the President the images captured of missile sites being constructed in Cuba.

Well, it turns out that US Presidents don’t get their priorities in a twist that easily and, despite the general impression that from that point on until the Soviets backed down 12 days later, there was a “Do not disturb” sign hanging on the White House door, JFK did in fact manage to multi-task throughout.

“What have I done?”

One of the things he succeeded in doing that very day whilst contemplating the potential death of an estimated 200 million people on both sides of the Atlantic, was sign into law the Revenue Act of 1962. This would not be worth mentioning had it not been for the fact that the Revenue Act of 1962 has probably had more lasting effect on the world than those bases in Cuba. It was that piece of legislation that introduced the American people to Subpart F of the Internal Revenue Code. The non-deferral of Controlled Foreign Corporation (CFC) income was born.

The US tax system that has been the vanguard of tax development since the early 20th century, has been through an evolutionary process as regards international taxation. Starting in 1918, at the end of the First World War, the authorities introduced a system of credits for foreign taxes paid so as to avoid double taxation. As they perceived breaches in the system they sealed them while, at the same time, showing increased fairness with underlying credits for taxes paid by the US owned foreign corporations that existed here and there.

Following the Second World War and introduction of the Marshall Plan to help get Europe back on its feet, there was an explosion in the number of US owned foreign corporations and Congress started to wake up to the possibility that US corporations, faced with massive taxes at home, might be shielding their profits in low tax jurisdictions. Hence, in 1962 – just in time for the possible destruction of mankind as we know it – legislation was passed to prevent the deferral of tax in foreign corporate tax planning strategies.

It has been downhill ever since. Countless changes in the law have led to a labyrinth of regulations that, it is generally believed, have left the US Treasury none the much richer while leaving tax lawyers and CPAs very much richer (I always had a soft spot for Kennedy). Meanwhile, much of the world has caught on to CFC which has become the byword in my profession for “This is complicated – we will need to give you a quote”.

What is of keen interest is the gradual move internationally away from a worldwide system of taxation, as practiced in the US, to a modified territorial system. The Territorial approach, which is also gaining traction in the US, broadly does not seek to tax or give foreign tax credit for dividends received by resident companies from foreign affiliates. The arguments in favour of a territorial system are broadly that they will allow companies to be entirely competitive in foreign markets and there will be free repatriation of income leading to increased investment at home. Against the territorial system is the argument that more activity and income will be moved offshore creating permanent tax advantages.

Astute readers will have noticed that somebody here, by definition, must be dancing with the fairies. The kindest explanation as to why both sides are able to claim that a territorial system will cause capital flows in precisely opposite directions, is that nobody really has a clue but they want to find support for their chosen philosophy of international taxation. The Worldwiders are firm believers in creating tax equality among resident taxpayers. The Territorials believe that you have to equalize the tax costs between international competitors that operate in the same jurisdiction, so that everybody is competing on a level playing field and capital can flow to where it obtains the best after-tax returns. It is worth noting, by the way, that the place where the best after-tax returns are achieved is likely not to be the place of most efficient exploitation of capital since the lower tax rate distorts the return.

Just get off your backside and do something!

Now, I like my dose of Kant and Descartes as much as the next man, but – in the real world (and that is the political world) – philosophy is to international taxation what a bicycle is to a fish. Governments need to balance budgets. Ask the Greeks – they gave philosophy to the world, and sadly not much else. Socrates, Plato and Aristotle will not save them from drinking economic hemlock. Governments do what they have to do and hope that some thinkers somewhere will support them.

In practice – and that is definitely the most important term in the taxation lexicon – 27 of the 34 members of the OECD (The “I am rich and couldn’t give a sod about the rest” club of wealthy nations) have adopted some form of territorial taxation – 10 of them since 2000. The most common features are: a reduced corporate tax rate to make the home country more competitive; the creation of a simplified CFC system or something similar to prevent blatant artificial siphoning of profits to low tax jurisdictions (Britain, a new convert to territorial taxation, is at the forefront of new developments on this); preferential tax treatment for the exploitation of local R&D since much of that siphoning of profits previously mentioned relates to dubious IP ownership in low-tax jurisdictions; preferential tax treatment of group finance companies to keep the finance income onshore; restriction of interest expenses at head office level to those used in the production of head office income so as not to unfairly reduce the home country tax base; and strict transfer pricing legislation to bayonet the wounded.

Meanwhile, real business profits from foreign operations are repatriated free of charge, or close to free of charge. Repatriation can still be a bummer where dividend withholding tax from the foreign jurisdiction is prohibitively high – but there too, several countries are moving towards low withholding taxes on substantial corporate holdings.

According to the statistics (I don’t believe I said that) this practical hybrid territorial system is working well which fits in with the one piece of tax philosophy I do subscribe to in my day job- “If it ain’t broke, don’t fix it”. On the other hand, the US system appears totally broke. Whichever way the election goes in November, the President and Congress should look closely at the experiences of their OECD colleagues. Fifty-odd years after the revolutions in Cuba and the US international tax system, it is time for legislators to show real courage and do what they were elected and paid to do.

A month shy of the 40th anniversary of its first broadcast, I was impressed when my teenage son asked me last week whether I had ever seen the Cheese Shop sketch. He was astounded when I started quoting from it and informed him that Monty Python had defined humour for my generation (sorry Yanks, it was not Benny Hill). For several months my mind has been filled with another of their skits that circumstances will simply not allow to fade away.

Those were not the days

When I first saw the Four Yorkshiremen sipping good wine and trying to outdo each other in exaggerated memories of their poverty-stricken childhoods (“I had to get up in the morning at ten o’clock at night half an hour before I went to bed”) I just found it very funny. When I grew up and read Orwell’s “The Road to Wigan Pier” that deals with the abject poverty and misery of the mining families of Yorkshire and Lancashire during the Great Depression, I realised its satirical greatness.

As Europe pulled away from the summer – reading, watching and listening to the media – you could be forgiven for thinking that the Euro Crisis was on its way out. Agreement on banking union, adoption by the ECB of ‘lender of last resort’ status and a green light from the German Constitutional Court for German participation sent government bond yields down in Spain, Italy and Portugal. At the same time Spain, Italy, Portugal and Ireland were congratulated for their austerity packages which only left Greece listing badly and looking like she is likely to sink.

Leave it all to the Irish. The Iranians wouldn’t know what hit them

Well, now that we are out on Autumn’s open road, all hell has broken loose as demonstrations and riots erupt across Europe against the austerity packages imposed on the citizens and residents of problem countries. The policymakers in Berlin, Brussels, Madrid, Lisbon and Rome seem to have forgotten one thing in their calculations. The suffering of the people. The Spanish are reduced to reminding us that they discovered the New World, the Italians are reminding us that they used to rule the world, the Portuguese are reminding us that they discovered South America (which explains why, when I travel to Brazil, I cannot understand a single word they say) and the Greeks continue to annoy us by reminding us that they created Western Civilization . Only the Irish, who discovered Guinness that has brought more happiness to men’s faces than all those discoveries put together, are shutting up and suffering in silence.

Of course, what all those nations did in their earlier incarnations is irrelevant in the show-me-the-money modern world. But what should be critical to policy makers is the here-and-now. And the here-and-now is not made up of central bank statistics of inflation targets, quantitive easing and long-term growth. The here-and-now is made up of people who need to live through today and tomorrow before they get to the long-term. The European Union is about people and if its pensioners are being deprived of their only potential source of livelihood and if 50% of youngsters cannot find work then – whatever the ECB statistics say – the European Union is setting itself up for its own fall.

And that is even before we get to the question of whether austerity measures are macroeconomically the way to go (the ongoing battle between the Keynesians – no way – and the followers of Hayek – absolutely).

The extent to which statistics have trounced humanity came home to me last week in, what is almost an aside to the whole shambolic situation. The Portuguese Prime Minister announced that, in an effort to encourage employment, his government was going to cut the Employer’s National Insurance contribution on workers’ salaries by 5.75%. Good economic sense but for one small point. In the same announcement he informed the public that Employee’s National Insurance contributions were going to rise by 7% to pay for the reduction thus slashing take-home pay.

The issue here is not whether costs need to be reduced and taxes raised but, rather, the socially destructive way in which that goal was to be achieved. By telling the man in the street, who understands as much economics as it is to his advantage to understand, that he is being forced to finance the profits of his already overprivileged employer is inviting that man in the street to clamber onto the barricades. Simply idiotic. When I recall that the current president of the European Commission is himself a former holder of the august position of Prime Minister of Portugal my hands start to shake involuntarily. In the meantime the Portuguese Government has backed down on this issue.

And then there is the macroeconomic situation. Most economists today (who happen to be neo-Keynesian) agree that austerity is not the right way forward in the short-term. The view stems from what Keynes called the Paradox of Thrift – that while good housekeeping including saving for a rainy day is an undoubtedly sound policy for individual households, at the collective national level it leads to a fall in GDP and recession. While targets should be set for the long-term, Governments should be allowed to run up bigger deficits in the short-term during a recession to protect their citizens and kick-start the economy.

People, not statistics

The irony is that several governments have already been given their marching orders by electorates for fouling things up. On the other hand, the troika charged with sorting things out are the EU Commission (non-democratic), the European Central Bank (non-democratic) and the International Monetary Fund (non-democratic and not averse to a bit of fun in New York hotel rooms). Of course, in the background conducting this Chamber Orchestra is a certain daughter of a Lutheran pastor. Her electorate is likely to boot her out in 2013 if she does not inflict some horrible pain on the recalcitrants. Which means the people can continue to be stretched on the rack, albeit with a little more slack than before due to recent developments at the ECB. The question to be asked is “How many more pensioners will need to commit suicide or how much will violence need to increase among the young unemployed, before those who make the decisions understand that the future of European society is not just about positive financial indicators derived from questionable econometric equations?”

Apropos, the Cheese Shop sketch has proved quite prescient. John Cleese, playing an intellectual prig, enters a boutique cheese shop with a view to assuaging his hunger. Live entertainment is provided by an unlikely duo of bowler hatted gents dancing in the Greek tradition to the accompaniment of a bouzouki. The shop is completely empty of cheese although the shopkeeper, Michael Palin, continues to give Cleese the impression that he has plenty of cheeses. Remind you of a country in Europe (there was a subtle clue in the text)? Anyway, the final part of the scene is where the analogy falls apart. Cleese tells Palin that he is going to ask him straight if he has any cheese and, if he answers “No” he will shoot him. The shopkeeper tells the truth.